Chapter26 Technical Analysis

8/2/2019 Chapter26 Technical Analysis

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Slides by:

Pamela L. Hall, Western Washington University

Francis & Ibbotson Chapter 26: Technical Analysis 1

Technical Analysis

Chapter 26


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Background

Main approaches to valuing stocks include

Risk-return analysis

Fundamental analysis

Technical analysisSome technicians use only technical analysis while

others use both fundamental and technical analysis

Technicians (AKA: chartists) focus on charts of

market prices and transactions statistics Think that these statistics will reveal all

Technicians study patterns in security prices


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Theoretical Foundation

Edwards & Magee (1997) state the basicassumptions of technical analysis A securitys market value is based on supply and

demand Supply and demand are based on both rational

and irrational factors

Security prices tend to move in persistent trends

Changes in trends occur due to shifts in supplyand demand

Shifts in supply and demand can be detectedusing charts of market transactions

Some chart patterns tend to repeat themselves


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Technicians believe past patterns will recur

Therefore can be predicted

Technical analysts estimate prices

Whereas fundamental analysts estimate value

Technicians tend to ignore issues such as a

firms riskiness and earnings growth

Instead focus on barometers of supply anddemand


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Technicians claim technical analysis is Easier

Faster

Can be applied simultaneously to more stocks than

fundamental analysis

But, does technical analysis work?

Technicians argue that when using fundamentalanalysis

Must wait until market realizes a stock is undervalued Must rely on inadequate accounting statements

It is hard work

Must use ambiguous estimates of growth


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The Dow Theory

Originated by Charles Dow

Founder of the Dow Jones Company and editor ofWall StreetJournal

Dow Theory presumes market moves in persistent bull and

bear trends Often used for market as a whole, but used for individualsecurities also

Types of movements defined by Dow theorists

Primary trends (bull or bear market)

Secondary trends (corrections)

Market collapses or upward surges lasting a few weeks or months

Tertiary moves (little daily fluctuations)

Meaningless random wiggles but should be studied to determine ifrelate to a primary trend


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The Dow Theory

Most Dow theorists do not think a new primary trend has been confirmed until pattern of

ascending or descending tops occur in both industrial and transportation averages.


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Testing the DOW Theory

Brown, Goetzmann & Kumar (BGK) testedDow theory using event study 255 WSJ editorials used as events

Neural net estimation used to identify optimaltrading rules during 1902-1929

Results indicate forecasts based on 4discernable patterns

Recent downward trends in DJIA are sell signals DJIA falls from recent peaks are sell signals

Recent upward trends in DJIA are buy signals

Recoveries from recent declines in DJIA are buy

signals


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Testing the DOW Theory

When a buy or neutral signal was detected, a

hypothetical portfolio is fully invested in

DJIA

When a sell signal was detected, a

hypothetical portfolio is fully invested in

cash

Tested from 1930-1997 Results indicate that some trend-predicting power

existed, but not enough to generate large excess returns


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Bar Charts

Represent price (high, low, close) of

security over time

Volume data is represented alongbottom

Second most important statistic to

technicians


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Head and Shoulders Formation

A series of reversals

Supposed to signal that a securitys price has

reached a ceiling and is expected to decline in the

future


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Head and Shoulders Formation

Left shoulder

heavy buying

increases priceto a peak before

lull in trading

pushes price

downward.

Heada spurt of

buying activity

increases price to

new high. Then a

lull in trading

decreases prices

to below top of

left shoulder.

Right shouldera

moderate rally

increases price

but not to a new

level equal to the

top of the head.

Confirmation

(breakout)the

price falls below

the neckline

which is a sell

signal.


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Other Patterns

Numerous patterns have been described bytechnicians, such as Triangles

Pennants Flags

Channels

Rectangles

Double tops Triple tops

Wedge formations

Diamonds


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Charting Volume of Shares Traded

Technicians argue volume measures

the intensity of investors feelings

Volume is studied in conjunction withprices

Technicians analyze resistance and

support levels along with volume


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Support and Resistance Levels

Resistance level Ceiling (peak) above which

stock price is not expected to

go Supply of security is expectedto increase

Support level Floor (trough) below which

stock price is not expected todrop

Demand of security is expectedto increase


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Support and Resistance Levels

Suppose the following occurred

Moderate surge in trading volume at Point

A

Larger surge in trading volume at Point B

3 times greater than surge at Point A

May surmise that some bullish new

information caused buying pressure atPoint B which overcame the previous

resistance at Point A


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Congestion Areas

Technicians are unable to offer reasons for

price actions like this

Penetrating support line means sell

Penetrating resistance line means buy

Studies examining trading range breakouts find

that, after deducting commissions, return was

slightly larger than riskless interest rate


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Congestion Areas

Price fluctuates in

first congestion

area for a while.

Price rises through $50 resistance

levelold resistance level

becomes new support level.


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Selling Climaxes and Speculative Blowoffs

When supply and demand are out of balance

(price is moving) volume is watched closely

Market is bullish when high volume is combined

with a rising price Market is bearish with high volume and falling

prices

Falling prices and high volume are

considered bullish if a selling climax occurs


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Selling Climaxes and Speculative Blowoffs

If one believes the end of bear market is nearand high volume occurs Means last of bearish investors are liquidating

their holdings Clears the way for bullish investors to start bidding upprice

A speculative blowoff marks the end of abull market High volume pushes prices to peak

Exhausts bullish speculators enthusiasm, enablingbearish market to begin

A bull dies with a bang, not a whimper


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The Confidence Index

Ratio of high-grade bond yields to low-gradebond yields Reveals how willing investors are to take risks

As investors grow more confident about economy, shiftfrom higher-grade bonds to lower-grade bonds (higheryields)

Increases prices of low-grade bonds which leads tolower yields which leads to an increase in confidenceindex

Barrons Confidence Index (BCI) Ratio of average yield from Barrons of 10 high-

grade bonds over average yield of Dow Jones 40bond index


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Interpreting the Index

Has an upper limit of 1 Yields on high-quality bonds will always be lower than

yields on low-quality bonds

Yield spread narrows during economic boom

Confidence index rises Technicians predict stock market will rise

BCI was at historically high levels (and rising) priorto stock market crash of October 19, 1987

Confidence index is positively correlated to stock

market over a complete business cycle However, sometimes it is a leading indicator, sometimes a

lagging one


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Moving Average Analysis

Moving averages are used to provide a smoothreference point for Individual securities

Market indices

Commodity prices

Interest rates

Foreign exchange rates

Some use a 150-day (30 week) moving average

Changes each day Most recent day is added and oldest day is dropped Following calculation is performed

M150DAPt = (1/150)(Valuet + Valuet-1+ Valuet-149)


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Moving averages computed over short time framesfollow daily prices more closely More volatile than longer-term moving averages

Technicians analyze difference between daily priceand moving average If daily prices penetrate moving average line it is a signal to

take action

If daily price moves down through a moving average, pricefails to rise for many months

Sell signal If daily prices are above moving average but difference is

narrowing

Signals end of bull market may be near


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Moving average analysts recommendbuying stock ifMoving average line flattens and stock

price moves up through moving averageline

Price of stock falls (temporarily) belowmoving average line that is rising

Stock price is above moving average line,falls, turns around and rises again withoutpenetrating moving average line


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Moving average analysts recommend sellingstock if Moving average line flattens and stock price

drops down through moving average line Stock price temporarily rises above a declining

moving average line

Stock price falls through moving average line andturns around only to fall again without

penetrating above moving average line

Strategy is more successful if movingaverage is calculated over a longer timeframe


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Can subscribe to chart delivery service

Can buy years of historical daily prices

and draw own chartsCan simulate trading by managing

hypothetical trades


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Empirical Tests of Moving Average Rules and

Congestion Areas

Brock, Lakonishok and LeBaron(1992) and Bessembinder and Chan(1998) test moving average trading

rulesProvide significant forecast power over

DJIA Found sample periods in which moving

average trading rule earned significant profits

Found many sample periods in whichsignificant losses occurred


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Patterns and Procedures

New patterns can be perceived at will

Similarities between technical analysis

and Rorschach ink blot testIntelligent technicians with good

imagination can perceive many different

meaningful patterns


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The Bottom Line

Technical tools are used to detect price patterns

Technical analysis assumes shifts in supply and

demand occur gradually over time

Price change pattern is extrapolated to predict futureprice changes

Many financial economists believe technical analysis

cannot predict market prices

Believe security prices are a random walk Occur in reaction to random arrival of new information

Believe a series of similar independent changes in prices

are coincidence

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Chapter26 Technical Analysis